The conventional view that long-term growth investors should have greater exposure to relatively stable developed markets in order to obtain the best potential returns does not hold true if one were to look at the average returns of these markets over the past 5- and 10-year periods. As a matter of fact, growth investors would have been better off if they had pumped more money into traditionally riskier emerging markets, which though more volatile, have on average substantially outperformed their developed counterparts over the 5- and 10-year periods ending October 15, 2008.

Whether investors should increase their exposure to emerging markets is therefore a question of their time horizon and ability to tolerate higher degrees of volatility and risk in order to obtain potentially greater long-term returns.

Phillip Armstrong, CEO of Jovian Capital Corporation in Toronto and a proponent of long-term investing suggests that investors should not generally hold more than 30 percent of their portfolios in foreign markets. However, he believes that if investors are looking for growth, they should increase their exposure to emerging markets, bearing in mind that “volatility should not be equated to risk.”

Currently only about 3% of the assets of all Canadian mutual funds are held in pure emerging market funds. However, funds with a global/international focus also hold emerging market assets, bringing the total emerging market exposure of mutual fund investors to about 10%.

Based on regional performance of the MSCI Price Index for the period ending October 15, 2008 in US$, the best performing MSCI Emerging Markets (EM) Latin American Index was up 17.34% over the 5-year period, while the EM Eastern Europe Index gained 15.33% over the 10-year period.

Comparatively, for developed markets, the best-performing MSCI EAFE Index was up a meager 2.11% over the 5-year period, while the MSCI Pacific Index was up 2.21% over the 10-year period. And if to rub salt into the wounds of those who held on for the long-term, the MSCI World Index lost money, -0.27% and –0.39%, respectively over the 5- and 10-year periods, whereas the supposedly blue-chip MSCI North American Index fared even worse with declines of -2.12% and -1.13%, respectively.

At a country level, the best performing developed market over the 5-year period was Denmark with a gain of 11.3%, which incidentally was the only market with a double digit rate of return. Canada ranked fifth with a gain of 7.27%. On the other hand, over the same period, Egypt, the top-performing emerging market produced a gain of 43.6%, with each of the top 10 emerging markets recording double-digit gains. Argentina, the tenth best performer among emerging markets returned 14.86%, whereas Switzerland with a gain of 5.77% was the tenth best performing developed market.

For the 10-year period, Russia led the emerging pack with a gain of 23.8%, while India held the tenth spot with a return of 13.28%. Among the developed markets, Canada, up 8.91%, was the best 10-year performer, whereas Sweden ranked number 10 with a gain of 2.42%.

Arguably, the fallout from the recent global credit crunch which sent developed markets into a tailspin in recent months resulted in the poor long-term performance of developed markets. But the truth is, emerging markets have lost even more ground amidst the chaos and yet remain ahead over the long term.

For instance, for the year-to-date period ending October 15, the MSCI World Index was down 40.18%, while the MSCI Emerging Markets Index lost 49.96%. Yet the Emerging Market Index was way ahead over the 5- and 10-year periods with gains of 8.85% and 8.96% respectively, compared to losses for the World Index for the same periods.

“Emerging markets are certainly more attractive over the long-term,” says Chuk Wong, vice president and portfolio manager of Dynamic Funds in Toronto, who has responsibility for the firm’s global value mandates. He however cautions that emerging market investors must be able to stomach a higher degree of volatility which is typical of these markets.

Wong claims that although emerging markets as a whole represent the second largest economic bloc in the world, behind the US, they are under-represented in major global stock market indices. There is therefore “scope for greater exposure” among investors, he says.

“There is no question that emerging markets as a percentage of global GDP is rising,” adds Bob Gorman, Vice Presi-dent and Chief Portfolio Strategist of TD Waterhouse in Toronto, alluding to the growing importance of emerging markets. He is not averse to increased exposure but like Wong advises that investors must be able to tolerate their “notorious volatility”. He suggests that investors can obtain indirect exposure to emerging market by investing in developed market companies that benefit from growth in emerging markets.

Brent Smith, Chief Investment Officer of Calgary-based Franklin Templeton Managed Investments, a division of Toronto-based Franklin Templeton Investments Inc.

Region	Year	Global Output Growth	Consumer Prices	Current Account Balance
		(% change over previous year)		(US$ billion)
Emerging Markets	2008 2009	5.9 3.1	6.4 4.3	695.0 312.0
Latin America	2008 2009	4.5 1.0	8.3 7.5	3.0 -78.0
EMEA	2008 2009	4.5 0.3	10.5 7.4	304 -56.0
Asia/Pacific	2008 2009	7.4 5.7	3.0 0.9	388.0 447.0

argues that emerging markets are generally characterized by higher growth rates than developed markets and consequently could potentially provide better returns. He also suggests that emerging market investors must have a long-term investment horizon and a higher tolerance for risk in order to benefit from potentially greater returns. “The risk-reward premium is high,” he says.

Smith adds: the scope for emerging markets remain bright – GDP growth is largely internally driven and is not overly dependent on external factors; middle class influence is driving their economies; their populations are relatively young; in many instances their banking systems, especially in Asia, are better than those of the developed world; and strong infrastructure development in some markets such as the Middle East is a catalyst for growth. He believes that the “risk premium of emerging markets will gradually shrink.” He contends that although the correlation between emerging and developed markets has apparently increased, negative sentiments towards emerging markets amidst the current crisis is greater than warranted given their relatively sound fundamentals.

Wong claims that the burring of lines between emerging and developed markets are largely responsible for the greater slump in relatively riskier emerging markets so far this year. Grammer argues that if only the US was affected by the global credit crunch then emerging markets might have fared better. However, the fallout in other areas such as Europe and Japan resulted in “a coordinated global slowdown in developed markets which impacted emerging markets.” He surmised, “no one has been able to get away from a crisis of this nature.”

Grammer adds that from a risk-reward standpoint, emerging markets remain favorable. He says that even in a slow-down, their growth rates on average will be higher than that of developed markets. “Emerging markets are probably the only place in the world where you will have positive growth for the rest of 2008 and the first half of 2009,” he says.

There is consensus that neither developed nor emerging markets will experience a massive recovery in the near term. Irwin Michael, president of Toronto-based I.A. Michael Investment Counsel Ltd. says that investors must first regain confidence in the markets. “Currently stock prices have no bearing on valuations; everything is liquidity driven,” he argues.

Looking ahead, Gorman expects continued volatility in the near term, before the markets – both developed and emerging – head higher. With valuations at relatively low levels, he sees significant buying opportunities. He thinks US blue chips represent a good buying opportunity.

Michael, a deep value stock picker, believes opportunities exist in companies with good balance sheets, tangible book values and the “wherewithal to make it happen in this difficult period.” Both Wong and Grammer see growth plays in the emerging world. Grammer argues that even though growth is slowing in China, for example, it will only slow to about 8 per cent annually, which is nonetheless very strong.

Evidently, emerging markets have typically provided greater long-term returns for growth investors who can stomach their volatility. Given that their economies are characterized by higher growth rates, it is most likely that long-term growth investors would be better off by increasing their exposure and waiting for the potential rewards.

Trowbridge focuses on international tax services for Canadians and U.S. citizens/residents around the world. For further information on their firm and the services they provide, you can contact them at their Toronto office at: Phone 416-214-7833 Email arun.nagratha@trowbridge.ca Web www.trowbridge.ca